1 Introduction A vast experimental literature finds that individuals are usually optimistic (i.e, they believe out comes favorable to themselves to be more likely than they actually are) and overconfident (i.e., they believe their knowledge is more precise than it actually is). Since optimism and overconfidence di rectly influence decision making, it is natural to ask how optimistic and overconfident managers will ffect the value of the firm. Are managerial optimism and overconfidence sufficiently detrimental to firm value that shareholders should actively avoid hiring optimistic and overconfident managers? What possible benefits might optimistic and overconfident managers bring to the firm? We use a simple model of capital budgeting to contrast the decisions of overconfident, optimistic managers with those of rational managers. We reach the surprising conclusion that managerial overconfidence and optimism can increase the value of the firm. Moderate overconfidence can align more closely with those of shareholders. However, extreme managerial overconfidence and optimism are detrimental to the firm. Our analysis starts with the observation that many capital budgeting decisions can be viewed as decisions whether or not to exercise real options(Dixit and Pindyck, 1994). Because of their greater risk aversion, rational managers will postpone the decision to exercise real options longer than is in the best interest of shareholders. As Treynor and Black(1976)write If the corporation undertakes a risky new venture, the stockholders may not be very concerned, because they can balance this new risk against other risks that they hold heir portfolios. The managers, however, do not have a portfolio of the corporation does badly because the new venture fails, they do not have any risks except the others taken by the same corporation to balance against it. They are hurt by a failure more than the stockholders, who also hold stock in other corporations, are hurt.” Since overconfident managers believe that the uncertainty about potential project is less than it actually is, they are less likely to postpone the decision to undertake the project. Thus moder ately overconfident managers make decisions that are in the better interest of shareholders than do rational managers. Overconfident managers also benefit the firm by expending more effort than rational managers, as they overestimate the value of that effort. Optimistic managers believe that the expected net present value of potential projects is greater than it actually is. Like overconfident managers, optimistic managers undertake projects more quickly than do rational managers. How1 Introduction A vast experimental literature finds that individuals are usually optimistic (i.e., they believe out￾comes favorable to themselves to be more likely than they actually are) and overconfident (i.e., they believe their knowledge is more precise than it actually is). Since optimism and overconfidence di￾rectly influence decision making, it is natural to ask how optimistic and overconfident managers will affect the value of the firm. Are managerial optimism and overconfidence sufficiently detrimental to firm value that shareholders should actively avoid hiring optimistic and overconfident managers? What possible benefits might optimistic and overconfident managers bring to the firm? We use a simple model of capital budgeting to contrast the decisions of overconfident, optimistic managers with those of rational managers. We reach the surprising conclusion that managerial overconfidence and optimism can increase the value of the firm. Moderate overconfidence can align managers’ preferences for risky projects more closely with those of shareholders. However, extreme managerial overconfidence and optimism are detrimental to the firm. Our analysis starts with the observation that many capital budgeting decisions can be viewed as decisions whether or not to exercise real options (Dixit and Pindyck, 1994). Because of their greater risk aversion, rational managers will postpone the decision to exercise real options longer than is in the best interest of shareholders. As Treynor and Black (1976) write: “If the corporation undertakes a risky new venture, the stockholders may not be very concerned, because they can balance this new risk against other risks that they hold in their portfolios. The managers, however, do not have a portfolio of employers. If the corporation does badly because the new venture fails, they do not have any risks except the others taken by the same corporation to balance against it. They are hurt by a failure more than the stockholders, who also hold stock in other corporations, are hurt.” Since overconfident managers believe that the uncertainty about potential project is less than it actually is, they are less likely to postpone the decision to undertake the project. Thus moder￾ately overconfident managers make decisions that are in the better interest of shareholders than do rational managers. Overconfident managers also benefit the firm by expending more effort than rational managers, as they overestimate the value of that effort. Optimistic managers believe that the expected net present value of potential projects is greater than it actually is. Like overconfident managers, optimistic managers undertake projects more quickly than do rational managers. How- 1